The Global Multi-Asset Market Portfolio

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PORTOFOLIO THEORY AND MANAGEMENT

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Market portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market, with the necessary assumption that these assets are infinitely divisible.

This portfolio contains important information for strategic asset allocation purposes:

• It shows the relative value of all asset classes
• It may also serve as the strategic point for investors who use framework^[1], or for those who follow adaptive asset allocation policies^[2]

• The authors were based on the Black and litterman model :

When used as part of an asset allocation process, the Black-Litterman model provides for estimates which lead to more stable and more diversified portfolios than estimates derived from historical returns when used with unconstrained mean-variance optimization. Because of this property an investor using mean-variance optimization is less likely to require artificial constraints to get a portfolio without extreme weights. Unfortunately using this model requires a broad variety of data, some of which may be hard to find.

The outputs from the model need to be fed into a portfolio selection model to generate the efficient frontier, and an efficient portfolio selected. The standard Black-Litterman model does not provide direct sensitivity of the prior to market factors besides the asset returns. It is fairly simple to extend the Black-Litterman model to use a multi-factor model for the prior distribution.

At a minimum, a Black-Litterman oriented investment process would have the following steps:

*Determine which assets constitute the market

*Compute the historical covariance matrix for the assets

 *Determine the market capitalization for each asset class.

*Use reverse optimization to compute the CAPM equilibrium returns for the assets

*Specify views on the market

*Blend the CAPM equilibrium returns with the views using the Black-Litterman model

*Feed the estimates (estimated returns, covariances) generated by the Black-Litterman model into a portfolio optimizer.

*Select the efficient portfolio which matches the investors risk preferences

• Practitioners using this framework need the market portfolio to derive the expected returns implicitly priced-in by all market participants by reverse engineering the mean-variance optimization problem. Then, they can express their own views and corresponding uncertainty to determine their optimal asset allocation. In addition, investors employing tactical asset-allocation strategies might use large deviations from long-term average market portfolio weights as a valuation indicator. But, aside from these practical considerations, the market portfolio is also interesting from a theoretical perspective.
• The Capital Asset Pricing Model : each investor should invest in exactly the same portfolio of risky assets, the market portfolio ; how much to invest depend on the investor’s risk aversion

An important application in the study: to determine the strategic asset-allocation weights of a CAPM investor who targets investing according to market capitalizations

➔ The aim of the study: constructing an invested market index (in order to determine the strategic asset-allocation weight of a CAPM investor)

This does not imply that this market portfolio has been the optimal portfolio in practice

In order to carry out their study, the authors followed the steps bellow:

• They distinguished the 8 asset classes ,

Equities

Private equity

Real estate

High-yield bonds

Emerging-market debt

Investment-grade credits

Government bonds

Inflation linked bonds

Then they estimated and tracked their world market portfolio from 1991 to 2012 and from 1959 for the 4 main asset classes (equities, Real estate, non-government bonds and government ones). However, they only include financial assets that are available to the general public. They compare the asset allocation of institutional global investors to the market portfolio

• They focused on the invested global multi-asset market portfolio which is the aggregate portfolio of all investors, where portfolio weights indicate the constitution of the average portfolio. It contains important information, as it represents the views of the global financial investment community with respect to the pricing of each asset class
• As they went forward in their study, the authors noticed that composing the historical market portfolio is not an easy task, since the data is not available for each of these asset classes over this historical period, therefore, they were aware of the uncertainty of these information, however, they found indications that the data represent a good estimate when they compare their findings with the ones revealed by other authors in the same period of time.

The Outline of the article: first, they discussed the current market portfolio and follow this with a detailed analysis of the period 1990-2012 for eight asset classes. Then, they showed the market portfolio for the four main asset classes for the period 1959-2012. Finally, they provided an overview of recent portfolio compositions of pension funds, sovereign wealth funds and endowments, to obtain an indication of the degree to which their allocation is a reflection of the market portfolio.  

1. The global market portfolio 2012

They describe their data sources and methodology in detail. Here, once again, they focused on the invested market portfolio. This portfolio is the opportunity set that is available to financial investors. They derive the global multi-asset market portfolio from a variety of sources that they consider to be effective in providing an assessment of the market size of an asset class.

• For equities: the data used was from the MSCI All Country World Index, because this standard index contains large and mid-caps. To this, they added the market value of the MSCI AC World Small Cap Index; both indices contain developed and emerging markets.

Here, they faced a complication due to the lack of data:

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